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Do Tax Cuts Stimulate the Economy?

 

 by James Kroeger

 

 

In order for us to understand the ultimate impact that income tax cuts have on the welfare of taxpayers, we need to understand their effect on both the purchasing power of individual taxpayers and the effect they have on the economy's aggregate supply.  These are two separate effects that overlap each other, but it is possible to isolate their independent effects.  The impact that an income tax cut has on the purchasing power of taxpayers (they gain nothing) is something that I address in another article.  In this essay I want to discuss the impact that a tax cut can have on the Supply Side of the economy, i.e., on the total amount of goods & services that the economy produces.

One important lesson that economics students learn when they are first exposed to macroeconomic theories is that producers and retailers are strongly influenced by aggregate demand.  Assuming nothing else changes, an increase in aggregate sales (expressed aggregate demand) generally prompts suppliers to produce and bring to market more goods & services.  If it appears you can sell more, it makes sense for you to produce or obtain more product to meet increasing demand.  Thus, if we want to understand the ultimate impact that across-the-board income tax cuts have on the supply-side of the economy, we will need to understand how they affect aggregate demand.

It is no surprise that income taxes deprive taxpayers of some of the money that they would otherwise have spent on consumption.  If this reduction in consumer spending was the only consequence of taxation, we'd be forced to conclude that tax increases always have a negative impact on the health of the economy.  Why?  Because any time money is spent in the economy, it becomes someone's income (wages, profits).  All incomes are dependent on the spending of others.  When aggregate spending drops, there is less money available to pay those incomes, so people lose their jobs.  Spending must occur in order for people to have jobs.

But there is more to the story.  The only reason why governments collect tax revenue from citizens is in order to spend it.  When governments spend money, it automatically becomes income to a large number of citizens.  So instead of causing aggregate spending to drop, an increase in tax rates actually causes it to increase.  Why?  Because some of the money that people receive as income from the government---that was originally obtained from taxpayers---would have been saved, if certain taxpayers (typically wealthy ones) had not used it to pay their taxes.  When the government collects & spends money that would have been saved, it is pumping money into the economy that would otherwise have been removed from it.

This can be a very desirable outcome if your country is suffering from any kind of unemployment.  The act of saving money may not be egregiously harmful to the economy most of the time, but it can do an incredible amount of damage if it “gets out of hand.”  The Great Depression, for example, occurred for one very simple reason: those who had money that they could have spent chose to save it instead, denying people jobs.  Those who would have been happy to spend that money did not have it in their possession.  It is a reality that economists summarize in the equation: income = savings + consumption (spending).

This relationship between spending, saving, and jobs is important.  The only reason why there is ever any unemployment is because too much saving takes place.  The only way it has ever been possible to reduce unemployment is through the increased spending of either individuals or firms or governments.  When can we say that an economy has finally achieved its optimal level of savings?  Answer: when there is no unemployment.  When can we say with certainty that there is too little saving taking place in an economy?  Answer: when the economy is booming, there is no unemployment, and hyperinflation is threatening.  Only then will an increase in net savings not threaten jobs.

Advocates of Supply-Side economics have apparently never realized that when they recommend across-the-board income tax cuts and matching reductions in government spending, they are proposing a policy that---all else equal---is guaranteed to either cause a recession or make any ongoing recession worse.  Across-the-board income tax cuts are contractionary (assuming matching spending cuts) because wealthier recipients of income tax cuts will save some of the extra disposable income they are given.  Since not all money that is saved is lent out to borrowers, there is a net leakage of money out of the economy whenever money is saved.

Tax cut enthusiasts like to refer to tax cuts as though the incomes of other people are not dependent on the money that would be returned to taxpayers.  They suggest, instead, that everyone's tax money ends up being sucked into a powerful Black Hole known as Big Government where it disappears forever.  The truth they ignore is that even if an income tax cut were designed to give refunds only to people who would be certain to spend all of it (poor people), it would still not provide any net stimulus to the economy.  When spending-cut-dollars match tax-cut-dollars, the money that refunded taxpayers would get to spend would have been spent by the federal government anyway.  This means that no net increase in aggregate spending can occur, so there is no net increase in jobs or incomes.

A fiscal policy initiative can properly be described as expansionary only if it ends up increasing total spending in the economy.  Tax cuts by themselves cannot do that.  In spite of this fact, nearly every introductory economics textbook in America today mentions tax cuts as one of the federal government's expansionary fiscal policy tools and fails to mention that tax increases are far more effective than tax cuts in stimulating the economy when the money that is collected in taxes would have otherwise been saved.  One unfortunate consequence of this educational failure is that we now have politicians in charge of America's federal government who have cut taxes repeatedly over the past few years in the mistaken belief that they would stimulate the economy.

The only reason why the Bush Tax Cuts did not plunge the economy into an even deeper recession is because the federal government increased its spending after Nine-Eleven using borrowed money to finance it instead of tax revenue.  Unfortunately, the stimulative effect of this increased spending was largely offset by the contractionary effect of the tax cuts.  Giving the largest share of a tax cut to rich people who are most likely to save a great deal of it is not a very intelligent thing to do when the economy is struggling to pull out of a recession.  The result has been a sputtering and long overdue 'recovery' that has created far fewer jobs than almost any economic recovery in American economic history in spite of the added benefit of historically low interest rates.

We are currently witnessing yet another failure of Supply-Side tax policy to produce the results that its advocates have always cheerfully predicted.  Their vain hopes have been driven by an almost theological belief that increases in aggregate savings will lead directly to increases in investment spending.  Many economists have encouraged acceptance of this presumed causal relationship because they've understood that---if true---such a premise would provide them with the ultimate justification of their constant efforts to reduce the tax burden of rich people.  With it, they've been able to depict an activity that can be very damaging to the economy (saving money) as something of a Supreme Economic Virtue.  Unfortunately, very little of this wishful thinking is true...

 

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Related Economic Analysis:

MAKE THE AMERICAN PEOPLE RICHER

THE MISUNDERSTOOD RELATIONSHIP BETWEEN SAVINGS & INVESTMENT

ARE INCENTIVES NEEDED TO ENCOURAGE INVESTMENT?

ECONOMIC POLICY

MEASURING SAVINGS AND INFLATION